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Corporate Investment and Asset Price Dynamics: Implications for the Cross-section of Returns





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    • Sauder School of Business, University of British Columbia. We appreciate helpful comments from Jonathan Berk, Peter Christoffersen, Lorenzo Garlappi, the editor Rick Green, the referee João Gomes, Rob Heinkel, Burton Hollifield, Leonid Kogan, Ali Lazrak, Eduardo Schwartz, Raman Uppal, Tan Wang, Yong Wang, Robert Whitelaw, and seminar participants at the University of Alberta, UBC, the 2003 conference on Simulation Based and Finite Sample Inference in Finance at Laval University, the 2003 Phillips Hager and North Summer Finance Conference at UBC, the 2003 Northern Finance Association meetings, and the 2004 American Finance Association Meetings in San Diego. Support for this project from the Bureau of Asset Management at UBC and the Social Sciences and Humanities Research Council of Canada (grant number 410-2003-0741) is gratefully acknowledged.


We show that corporate investment decisions can explain the conditional dynamics in expected asset returns. Our approach is similar in spirit to Berk, Green, and Naik (1999), but we introduce to the investment problem operating leverage, reversible real options, fixed adjustment costs, and finite growth opportunities. Asset betas vary over time with historical investment decisions and the current product market demand. Book-to-market effects emerge and relate to operating leverage, while size captures the residual importance of growth options relative to assets in place. We estimate and test the model using simulation methods and reproduce portfolio excess returns comparable to the data.

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